Remember Remember the 6th of November*

Posted on October 25, 2018

Investors tend to shy away from getting into the business of predicting election outcomes, especially given the misses of even the most adept pollsters in recent years, but markets can’t seem to resist taking a view when given the chance. So as the first Tuesday in November looms, we find it helpful to arm ourselves with some election numbers and a quick refresher on some dynamics at play in U.S. politics.

Let’s do some basic math to set the scene:

There are 435 seats in the House of Representatives and all seats are up for election every two years. It takes 218 seats to hold a majority. If we sort all vacant seats by the party that most recently held them, Democrats hold 195 seats and Republicans hold 240. So Democrats must gain a minimum of 23 seats and Republicans can lose up to 22 seats for majority control in the House.

In the Senate there are 100 Senators, and 35 are defending their seats, as Senators only need to run for re-election every six years. Democrats have 47 seats in the Senate and Republicans have 51. There are two Independent senators who caucus with Democrats; we’ll consider them Democrats for simplicity’s sake, which bumps Democrats to 49. It takes 51 votes to control the chamber, but Vice President Mike Pence has the power to break any 50-50 tie by siding with Republicans. So Republicans can lose one seat to maintain their effective majority, while Democrats must defend all 26 incumbent seats and steal two more from Republicans for a net gain of two in order to take control of the Senate.

The odds:

Markets and most political pundits are anticipating a split majority outcome where Democrats take the House and Republicans maintain control or pick up seats in the Senate. This divided government outcome is favored by betting markets and a number of external election models.[i] Current polling shows Democrats ahead in the national generic ballot by an average spread of 7 points, which has moved within a range of around +3 to +13 since July of 2017.[ii] Why such a bifurcated outcome if the generic ballot polling lead shows such consistent recent support for Democrats? Put simply, Democrats are competing to take over seats in the House across a number of purple, independent-leaning areas, while a number of “red-state” Senate Democrats are facing steep odds of defending themselves from Republican challengers. The battleground for the House is across a number of suburban, swing districts whereas the fight for the Senate is in number of recently red-leaning states where Donald Trump won the Electoral College in 2016.

Beyond the math: What do the potential election results mean for investors?

Where the outcome matters most for markets is at the extremes. Investors will be watching how the odds of the tail scenarios evolve and what any surprises could mean for the post-election policy landscape. Below are some potential policy outcomes for the three scenarios, including the favored divided government model, and the tail events of a sweep of both chambers by either party.

If we get divided government:

House Democrats could seek to handicap the White House and their Republican colleagues, while Republicans use their Senate majority to fend off any serious Democratic policy moves.

The two parties could attempt to strike a grand bargain with the White House over a trillion dollar infrastructure spending bill, which both sides have said they support in recent years. But take note: while talk of infrastructure spending could provide politicians with a way to brag to constituents about passing a gleaming public works plan, the road to passage will be bumpy and largely uncertain due to arguments over how to fund it.

If Republicans hold both the House and Senate:

Republicans and the White House would see the outcome as a renewed mandate for their public policy platform.

Republicans could try to enact another round of tax cuts that will go into effect once the fiscal boost of the first round fades. We may even see more rhetoric ahead of the midterm vote on a “middle class tax plan,” which President Trump gave the press a taste of at rallies over the weekend.[iii] Bond yields rose in anticipation of the first Republican tax cuts passed at the end of 2017. It’s possible the market could react in a similar fashion if Republicans have a strong showing.

The GOP may also try to reform entitlements as a means of tightening Congressional purse strings. We saw a first glimpse of this strategy last week when Senate Majority Leader Mitch McConnell hit the Bloomberg airwaves, and discussed the newly released federal budget figures.[iv] The U.S. Treasury Department’s report showed a $779 billion deficit in fiscal year 2018, up 17% from the prior year.[v] Republicans have typically been known as the party of fiscal discipline, so they may revert to their traditional programming regarding the swelling deficit, but the proof is in the pudding here. We may not be through with the late cycle fiscal boost just yet.

If Democrats take both chambers:

Assuming Democrats don’t gain the 60 votes needed to silence a filibuster in the Senate or the two-thirds majority needed to override a Presidential veto, Democrats are likely to:

Obstruct the White House agenda.

Demonstrate policy goals they would enact if they were to take control of the Executive branch by passing legislation that will die once reaching the President’s desk, including a bill on Medicare for all, reinforcement of the Affordable Care Act, a $15 minimum wage proposal, a bill on debt-free public college, net neutrality, and potential reform of the recent tax bill to target the middle class.

On China and Tariffs:

We’re unlikely to see an outcome that meaningfully moves the needle on current White House trade policy. Although lawmakers on both sides of the aisle have expressed concerns about the White House’s escalation of a Trade War with China, we’re doubtful that the two parties could successfully cooperate long enough to tie the President’s hand on trade. Moreover, both parties have members in their ranks who deride the post-Bretton Woods era of globalization as out of touch with the needs of modern workers. In other words, an antagonistic stance toward China and free trade is likely here for the medium term regardless of the outcome this November.

All this is to say that the midterm election odds matter for markets, but our job as investors is to not only decipher the numbers game, but to also reconcile campaign rhetoric with reality. As we close in on the final days of campaigning, we’ll be looking out for any signs of an election surprise and the impact of future US public policy on markets.

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